[UNLOCKED Early Look] Problems

***This is a complimentary look at the Hedgeye Early Look. While typically written by CEO Keith McCullough, today's note was written by U.S. Macro analyst Christian Drake. We encourage you to consider subscribing and leaving tired consensus research behind.

Tepper’s fundamental and valuation concerns are really just manifestations of our current late-cycle reality and a recapitulation of our 2Q15 #LateCycle Macro Theme.

We don’t always agree with Tepper but, when we do, we like to do it 3-months and 150 SPX handles ago.

(The prescient cartoon above was published one year ago this month.)

Macro grind

Since 2 & 20 sourced soundbites still grab more headlines than Hedgeye’s #BlueCollarMacro mouthpiece, Tepper’s comments yesterday offer a worthwhile opportunity to review some of the fundamental market data and contextualize the current expansion within the historical late-cycle experience.

First, The Cycle: Let’s take a quick step back to re-remember the archetypical economic cycle – from the perspective of the current cadre of policy makers.

Macro cycles, left to themselves, follow a pattern that largely resembles the circular, counter-clockwise flow captured in the inflation-output loop depicted in the 1st Chart of the Day below.

The conventional view is that the level of output drives inflation which, in turn, drives the policy response. These output-inflation cycles were the prevailing macro reality when the present global policy making oligopoly was coming of age and conventional monetary policy is designed to function within the context of this naturally evolving cycle.

The broader goal of current policy efforts is to both jump-start and subsequently smooth such a cycle in the face of persistent cyclical challenges and glacial secular shiftings.

POLICY = LOST IN TRANSMISSION

The Phillips Curve and the aforementioned output-inflation cycle on which conventional monetary policy is based has been so loose over the last 2 cycles (& the present one) as to be non-existent.

Meanwhile, the empirics on Janet’s hoped for policy flow through to Main Street remain dismal. Labor’s Share of National Income – which, historically, only rises at the tail end of an expansion and after growth and profits have been strong for a protracted period – remains at a multi-decade trough. Even if we follow the pattern of gains in the late innings of expansion it won’t close the gap – and, if it does, it will likely come alongside a step function move lower in corporate profitability and EPS growth.

The other side of rising inequality and top-heavy income distributions is lower highs and lower lows for labor income.

VALUATION = AN ANCHOR, NOT A CATALYST

Valuation is not a catalyst and from a short-to-medium term risk management perspective, it sits somewhere near the middle-bottom of our consideration hierarchy.

That said, over the longer-term, valuation certainly matters in anchoring return expectations and we don’t discount it as a factor completely, particularly as it moves towards extremes in either direction. Underneath the technicals, acute policy catalysts, and reflexivity that drives immediate and intermediate term price trends sits the steady drumbeat of fundamentals and an accordion-like tether to ‘fair value’.

Because investor’s maintain varying proclivities for particular multiples and conceptual valuation frameworks, one measure we track is a valuation composite which represents an equal weighted composite of three of the most widely used conventional valuation metrics: Shiller PE, SPX Market Cap-to-GDP and Tobin’s Q.

We review each in turn below but the broader conclusion is straightforward: current valuations are richer than at any point except the nose-bleed tech bubble highs. As we’ve highlighted, lower neutral policy rates and perma central bank interventionism may indeed be supportive of higher mean valuations but that only modestly dilutes the conclusion. When valuations are in the top decile of LT historical averages, subsequent returns over medium and longer-term periods are just not that compelling.

Shiller PE: Inclusive of the hundred’s of billions of market cap lost in the recent correction, the Shiller PE remains above 24x and sits just south of the top decile of its historical range. Mapping the Shiller PE by decile vs subsequent market performance suggests return expectations should move systematically lower alongside incremental increases in valuation. Historically, 1Y and 3Y returns progressively decline for each decile change in the Shiller PE.

Tobin’s Q: Longer-term valuation arguments center on the premise that returns on capital should equalize to cost of capital and market values should normalize to economic value. Tobin’s Q ratio is not a measure we use to tactically manage risk, but we can appreciate the intuition underneath its application – why buy an asset when you can re-create it for less and compete away existing, excess profit. Historically, at extremes, it has served as a solid lead signal for subsequent market performance. Currently, the q-ratio sits at ~1.06 and greater than 1.3 standard deviations above the long-term mean value – a level that has generally not been a harbinger of positive forward returns historically.

S&P 500 Market Cap-to-GDP: Assuming the collective output of SPX constituents credibly reflects aggregate national production (or serves as a credible proxy for it), the Market Capitalization-to-GDP ratio effectively represents a price-to-sales multiple for the economy. At current levels we are well above both the LT average and the 2007 highs.

The Chart of the Day below shows the valuation composite using the most recent data for the respective metrics.

PEAK PROFITABILITY

Earnings, Corporate Margins and collective SPX profitability all peak mid-to-late-cycle and the last few quarters of data suggest we’re probably past peak in the current cycle (ping sales@hedgeye if you’d like to review our 2Q/3Q Macro Themes decks).

In a low-to-no growth environment where the pie size stays the same, peak margins are good until they aren’t and are probably a symptom of policy ineffectiveness (in terms of flow thought to Main St.) more than not. Unless you think peak returns to capital provide a sustainable path to aggregate demand growth in the face of negative trend growth in real earnings, trough returns to labor, middling productivity growth and secularly depressed investment spending, then the mean reversion risk for operating margins remains asymmetrically to the downside.

2Q15: As Keith highlighted yesterday, with 2Q earning largely rearview for SPX constituents, the final score shows revenues and earnings down -3.5% and -2.2% year-over-year, respectively. Yes, the commodity rout was an outsized impact to energy/industrial’s profitability and this year’s collapse becomes next year’s comp but still, negative top & bottom line growth is not the stuff escape velocity, private-sector handoffs are made of or multi-year tightening cycles anchored on.

Today is Patriot Day. To those who serve(d) in the military and those, more broadly, who go underpaid and underappreciated in service of our greater good, your selflessness does not go unnoticed and your sacrifice will not be forgotten. We are sincerely grateful for your effort.

To hope & humanism, doing the right thing when no one is looking and blue collar alpha,

With TLT doing it's job (again) +1% on the day in another down US stock market tape, this is not an easy signal for me to send out - and maybe that is precisely the point...

I spend a lot of time thinking about what our GIP Model (Growth, Inflation, Policy) is signaling. When we have heightening convictions on what we call a Phase Transition (going from bearish to bullish TREND or vice versa), we make that call.

2. INFLATION - signaled #Deflation in Q3 of 2014 and have not yet signaled any Phase Transition from that TREND

The problem with making a call on POLICY (from here into the Fed meeting next week) is that I have no idea what the Fed is going to do. My confusion on POLICY risk should not to be confused with:

A) What they should have done - started raising rates in SEP 2013, so that they'd have room to cut, eventually and/or

B) What they should do now - nothing as tightening into a slowdown isn't modern day monetary policy rules

What scares the hell out of me is that they still don't know what they want to do - and they have to decide within a week.

Will that decision be based on what the US Equity Futures do in the next 3 hours or 3 days of trading? Or will it be based on "proving they can" despite Fund Fund Futures saying they shouldn't?

Consensus Macro may not, but we know growth (globally and locally) is slowing. We don't know what Janet Yellen is going to do with that. So I'd rather take down some Treasury Bond market exposure to an open-the-envelope event, then revisit on the event.

I've never gone broke getting out of the way when I wasn't highly convicted in the next move. This SELL (some) signal is consistent with both my track record in markets and life in general.

KM

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09/11/15 12:17 PM EDT

WAB: Adding Wabtec to Investing Ideas (Short Side)

Takeaway:We are adding Wabtec (WAB) to Investing Ideas on the short side.

Please be advised that we are adding Wabtec (WAB) to Investing Ideas on the short side today. Our Industrials Sector team lead by Jan Van Sciver will send out a full stock report to subscribers next week.

* * * * *

In the meantime, here's a brief background note from CEO Keith McCullough:

One thing I am very certain of is that the Federal Reserve can't print growth.

So we want to stay with our best Industrial and Cyclical Ideas on slow-volume bounces. Wabtec is still on Jay Van Sciver's SELL list. As a refresher, his contrarian short call on the stock was recently updated as follows:

WAB: They See A Downturn Coming?

WAB announced a large, long anticipated acquisition of Faiveley. A few thoughts:

1. The deal is likely to make strategic sense, unlike some of WAB's other recent transactions.

2. The driver for getting this deal done ('why now?') may be the need to plug a hole in the freight rail outlook. In that sense, it may be a sign of weakness - acquisitive industrials push acquisitions when they need them.

3. The price doesn't seem that bad, particularly in light of the recent dollar strength, although WAB is issuing equity. Issuing high multiple equity for lower multiple equity is a classic roll-up strategy.

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Lululemon: In Search of TAIL | $LULU

Takeaway:This quarter was a mess due to factors far beyond financials. LULU isn’t articulating a cogent plan – because it probably doesn’t have one.

This unlocked research note was originally published September 10, 2015 by Retail Sector Head Brian McGough and his team. For the record, McGough's team added Lululemon (LULU) to its Best Ideas list on 6/15/14 at $37.61 and removed it on 3/24/15 at $63.30 for a 68.3% gain. If you are an institutional investor interested in learning more about how you can subscribe to our research please email sales@hedgye.com.

There’s one major reason why we think this LULU quarter was a huge let down -- and it’s not that inventories were up 23 days while Gross Margins missed by 200bps. Nor is it that LULU added $62mm in revenue year over year, but generated $1mm less in EBIT. It’s the reality that this company does not know what it wants to be. Virtually every statement out of management on the call had to do with near-term tactical branding, marketing and product plans. All that is fine. It matters on some level – and definitely matters to small scale moves in the stock in the coming quarters. But that’s what we call TREND (in HedgeyeSpeak that translates to 2-3 quarters out – the near-term modeling horizon). This is where LULU lives, unfortunately.

But LULU needs a change of address. This is an extremely powerful brand in a solid, yet increasingly competitive, space. LULU needs to not only be a great brand, but a great company. Then and only then will it be a great stock. We think management is coasting on the power of the brand, by tweaking a legacy operating plan, blindly opening stores, and hoping that nothing else goes wrong. Hope, however, is not a profitable growth process.

LULU needs to live in the TAIL (which we define as 1-3 years). What we need for real wealth creation with this stock is for a clear, concise strategy that insiders rally around and are paid handsomely to implement. People need to look to $4.00 in earnings power, and believe in it. It’s that same strategy that would result in its CEO standing up and saying things that will make Nike, UnderArmour and Athleta quake in their boots (which used to be the case) – not that they are using ‘Sports Psychology on the Pant wall’. Unfortunately, we truly think that LULU does not have a proactive process to grow its business.

Does The Company Have A Long Term Plan?

Somebody, please, ask virtually anyone in the company if they know their market share in stores and online within an hour’s drive of each store. [Note: our math shows it ranges from 2.5% (Long Island) to 26.7% (Burlington Vt) -- ping us if you want the data]. We don’t think they’ll tell you – because they probably don’t know.

How can a CEO stand up and give credible growth and profitability targets without knowing these basic building blocks? How can they articulate why they don’t have a wholesale model – something that could be a home run for LULU (i.e. sell where the consumer shops)? Even the CFO, who we have/had high hopes for, hasn’t created his own identity with the Street – as he’s following the same script of his predecessor who was pushed out.

All we get from the company as it relates to strategic initiatives are 1) Brand, 2) Community, 3) Innovation, and 4) Guest Experience. The only quantified metric is that LULU will return to a 55% gross margin – something that we don’t think is realistic without meaningful backing by the balance sheet (i.e. more capex to boost profitability). But more importantly, the market is highly unlikely to pay for a passive goal to return to peak profitability when LULU is in a different stage of its growth cycle.

This is a great Brand, for the time being. We really want to get behind this story due to the potential that can be unlocked. But without the backing of a great company – we think this stock is going anywhere but up. We’re glad we pulled the plug in March.

Housing Macro: “Jobs Hard to Fill” | The domestic macro calendar was relatively light this week but we did get the NFIB small business confidence data for August. As a reminder, Small Businesses represent over 99% of total U.S. Employer firms and >60% of net private sector hiring on a monthly basis – and sentiment around the current and forward prospects for business activity are discretely related to hiring activity and labor compensation trends. Notably, the NFIB’s “Jobs Hard to Fill” sub-index rose +4pts sequentially to match its highest level in the post-crisis period. In the housing sector, as we highlighted last week, with both resi construction employment and hourly wages growing at approximately 2x the broader averages, tight labor conditions in the sector continue to manifest. The latest survey data from the Associated General Contractors (see AGC/WSJ figure below) lends further support to the tight supply view as a majority of firms are reporting difficultly in hiring employees across all the principal trades.

Performance Roundup: The mean/median QTD returns for the 14 homebuilders in the tables below are -5.3% and -4.9%, respectively. This compares with the S&P 500 being down -5.4% QTD, so roughly in-line. The broader Housing complex, however, is flat to up +2.6% QTD based on the ITB, XHB and S15 Home Index. We think this comports with our call to de-emphasize the builders on a relative basis for 3Q in order to sidestep their seasonally weakest period. The best performance QTD continues to come from NVR (+15.5%) - one of the two builders we favored for 3Q15. The other was Toll Brothers, which is down -3.2% for the QTD. Hovnanian remains the worst performing builder this quarter (-24.4%), but has seen a big bounce in the last 5 days, rising +16.2% on earnings.

Valuation: The cheapest names in the group currently are Meritage Homes (MTH) at 9.2x NTM earnings, Taylor Morrison (TMHC) at 9.6x and TRI Pointe Group (TPH) at 9.7x.

Joshua Steiner, CFA

Christian B. Drake

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09/11/15 08:52 AM EDT

FINANCIALS SENTIMENT SCOREBOARD - First American (FAF)

Takeaway:The title insurers have been and remain our go to Housing longs in 3Q. FAF remains compelling on its still bombed out sentiment (17).

This morning we are publishing our updated Hedgeye Financials Sentiment Scoreboard in conjunction with the release of the latest short interest data last night. Our Scoreboard now evaluates over 300 companies across the Financials complex.

The Scoreboard combines buyside and sell-side sentiment measures. It standardizes those measures to an index of 0-100, where 100 is the best possible sentiment ranking and 0 is the worst. Our analysis shows that a contrarian strategy can be employed successfully by taking the other side of stocks with extreme readings in sentiment, either bullish or bearish. Once sentiment reaches these extreme levels, it becomes a very asymmetric setup wherein expectations become too high or too low.

We’ve quantified the tipping points for high and low sentiment. Specifically, we've found that scores of 20 or lower have a positive, average expected return while scores of 90 or greater are more likely to underperform.

Specifically, our backtest of 10,400 observations over a 10-year period found that stocks with scores of 0-10 went on to produce an average absolute return of +23.9% over the following 12-month period. Scores of 10-20 produced an average absolute return of +11.9%. At the other end of the spectrum, stocks with sentiment scores of 90-100 produced average negative absolute returns of -10.3% over the following 12-months.

The first table below breaks the 300 companies into a few major categories and ranks all the components on a relative basis. The second table breaks the group into smaller subsectors and again gives them relative rankings within those subsectors.

This week we're flagging First American (FAF - Score: 17) as a long as our 3Q15 call to "hide out" in Housing favors the title insurers.

The following is an excerpt from our 90 page black book entitled “Betting Against the Herd: Generating Alpha From Sentiment Extremes Across Financials.”

Let us know if you would like to receive a copy of our black book, which explains this system and its applications.

BUYS / LONGS: Financials with extremely low sentiment readings of 20 and below on our index (0-100) show strong average outperformance in absolute and relative terms across 3, 6 and 12 month subsequent durations. Stocks with sentiment ratings of 20 or lower rise an average of +15.1% over the next 12 months in absolute terms.

SELLS / SHORTS: Financials with extremely high sentiment readings of 90 and above on our proprietary sentiment index (0-100) demonstrate a marked tendency to underperform in absolute and relative terms across 3, 6 and 12 month subsequent durations. Stocks with sentiment ratings of 90 or greater fall in value an average of -10.3% over the next 12 months in absolute terms.

Joshua Steiner, CFA

Jonathan Casteleyn, CFA, CMT

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